Even if you’ve never traded options before, you may be familiar with using them as a way of making leveraged bets on the performance of stocks or ETFs.
For less than the cost of the underlying investment, you can get the same upside (or downside) exposure as owning (or shorting) 100 shares of a stock or ETF.
What you may not be quite as familiar with is using options as an income-generating strategy. If you’re a seller of options, you can take advantage of time decay (their built-in lifespan) to generate steady income on both the buy and sell side of a stock you’re already interested in owning.
Today, we’re going to share a popular options strategy known as “The Wheel.”
Using it, you can “wheel” in and out of the same position (depending on what happens with the share price) while consistently capturing options premium.
The goal of the strategy is to bring in options premium on a continual basis. This allows investors to use the premium for income or to simply lower the cost basis of their position. How you choose to use the premium is ultimately up to you.
The Wheel
The wheel options strategy is an inherently bullish, mechanical, options income strategy known by names like the covered call wheel strategy, the income cycle, and the options wheel strategy.
It’s a systematic approach to options trading that allows you to create a steady stream of income on stocks you want to or already own.
The mechanics are simple.
- Sell Cash-Secured Puts on a stock until you are assigned shares (100 shares for every put sold)
- Sell Covered Calls on the assigned stock until the shares are called away
- Repeat the Process!
Basically, find a highly liquid stock that you are bullish on and have no problem holding over the long term. Once you find a stock that you’re comfortable holding, sell out-of-the-money puts at a price where you don’t mind owning the stock.
Keep selling puts, collecting even more premium, until eventually you are assigned shares of the stock at the strike price of your choice.
Once you have shares of the stock in your possession begin the process of selling calls against your newly issued shares. Basically, you are just following a covered call strategy, collecting more and more premium, until the stock pushes above your call strike at expiration.
Once that occurs, your stock will be called away, thereby locking in any capital gains, plus the credit you’ve collected.
Let’s go through an example to show you exactly how this options income strategy works.
The Wheel – Step One
DraftKings (DKNG)
DKNG is currently trading for 43.21.
Let’s say we are comfortable owning shares of DraftKings approximately 10% below where the stock is currently trading.
As a result, we decide to sell puts at the 39 put strike, 9.7% below the current stock price and more than 20% below its 52-week highs.
We can sell to open the December 20, 2024, 39 puts for roughly $0.50.
By selling the 39 puts for $0.50 our return is 1.3%, cash secured. Our breakeven stands at 38.50 per share and will continue to decline every time we sell premium.
If DKNG stays above our 39 put strike at expiration, we begin the process of selling puts again, thereby creating more premium to use as income or to lower the cost basis of our position. So, if we bring in 1.3% every 30 days or so, and we can sell puts roughly 12 times over the course of a year (if the stock stays above our chosen short put strike) our annual return is 15.6% on a cash-secured basis. Again, it bears repeating, we can use that capital to either produce a steady stream of income or to lower the cost basis of our position. In our case, we are selling premium to lower the cost basis of a stock that we want to own.
But what if DKNG closes below our put strike?
No biggie. We are issued or assigned shares at the price where we wanted to buy the stock. Think about it for a sec. We collect a premium to wait for a stock to hit our chosen price.
The Wheel – Step Two
So, let’s say DKNG closes below our 39 put strike at expiration. If so, we are issued 100 shares at $39 for every put contract we’ve sold. (Remember though, our net price is $38.50, $39 minus the $0.50 per share we received in premium.)
Once we have shares in our possession, we begin the process of selling out-of-the-money calls against our shares, which begins the covered call portion of the wheel options strategy on DKNG.
Now the question is which call strike to choose. Again, ultimately it just comes down to preference. My preference is to focus on call strikes that have a delta between 0.20 to 0.40.
Let’s say DKNG drops down to our 39 strike price and we buy shares there and we then decide on selling the 43 calls against our newly issued DKNG shares.
Right now, a contract that is $4 out of the money would sell for roughly $0.75 per call contract with a delta of .27.
That’s a 1.7% covered return in 30 days.
Of course, that assumes that the shares close below but near our short put strike. Once shares are actually assigned, a good rule of thumb is to look around 30-60 days out for contracts in the delta range specified above.
If DKNG stays below our 43 call strike at expiration we begin the process of selling calls again, thereby creating more premium to use as income or to lower the cost basis of our position. So, if we bring in 1.7% every 30 days, and we can sell calls roughly 12 times over the course of a year (if the stock stays below our chosen short call strike) our annual return is 20.4%. Again, it bears repeating, we can use that capital to either produce a steady stream of income or to lower the cost basis of our position.
But what if DKNG closes above our short call strike?
Again, no big deal. Our shares are called away, so of course, we keep our $75 ($0.75 covered call premium per share x 100 shares) per call contract, plus we are able to reap any capital gains from our stock. In this case, our capital gains would be 10.3%, for a total return of 12% if DKNG rose to our strike price and shares were called away.
Once our shares are called away, the wheel options strategy cycle ends, and the decision has to be made whether or not to continue using the strategy with the same stock.
The wheel options strategy is one of several wonderful options income strategies for those wanting to generate steady income, with lower risk compared to most options strategies. It also gives investors an opportunity to lower the overall cost basis of a position.
The strategy isn’t a get-rich-quick strategy; rather, it’s a methodical, systematic approach to trading options that generate consistent returns, month after month, on stocks or ETFs that you want to hold in your portfolio over the long term.
